Thursday, 5 July 2012

A banker, a pharmacist and physicist walk into a pub .... and pay $3 billion

One of my favourite jokes: "I make all the big decisions at home - what our policy on Iran, Chinese exchange rates and the Eurozone crisis should be. I leave the mundane issues - like where we live, how we raise our children, where we go on holiday - to my wife". Given the news coverage yesterday, dominated by Barclays, the Higgs-Boson and GSK there could be a version "Physical scientists investigate all the important questions - the origin of the universe, the existence of the Higgs Boson and why the dinosaurs became extinct. We leave the mundane issues - like why banks fail or how to respond to the diabetes epidemic - to the Social Scientists".

A Higgs Boson like(?) particle has been found, modulo a "5-sigma" event - recall Goldman's heralded the Credit Crisis in August 2007 by going public with a much (much, much, much) more rare 25-sigma event. Call me churlish, but having spent $3 billion plus (and the plus is augmented by much of the fitting, commissioning and operation of the machines is done by PhD students working at levels that would probably breach the European Working Time Directive and UK minimum wage legislation, luckily its in Switzerland) it was inevitable that they would find the Boson. A bit like it was inevitable that Wayne Rooney, the "white Pele", apparently, would play a central role in England's Euro 2012 performance, because he costs Manchester United so much.

My point is, if the UK's contribution to the $3 billion LHC had been diverted into serious scientific study of markets, involving many disciples and not just the Platonic forms of neo-classical economics, things might (modulo a 5?-sigma event) be different in the sense that people might (modulo a 5?-sigma event) be better off. The trouble is, the "scientific establishment" rarely take the social sciences that seriously, possibly because it is about "us" and not "things", and so rarely give it priority in funding.

In this respect, mathematics is a social science. In 2010 the outgoing "President of the Board of Trade" for the UK, Lord Mandelson, who was responsible for signing off the science funding budget, allocated some £40 million to enhancing Blackpool Tower, about the same as he allocated to maths research that year. Enhancing the imitation of the French Eiffel Tower rather than enhancing the imitation of French achievement in mathematics. Mathematics enables experiment when there is no apparatus - the Higgs Boson was (is) a mathematical object that exists as a physical(?) object because $3 billion has been spent to build the lab for the physical experiments. This is why mathematics is fundamental to understanding markets, because we cannot undertake experiments in markets, not because asset prices are Levy processes.

Bio-tech, is firmly in the camp of legitimate science since Tony Blair bet the UK's research pot on in 1997. However, bio-tech has not grown in the past 15 years in the same way that finance has grown, Blair's investment has not paid dividends. Just as the ethics of big banking are in crisis, so are the ethics of big pharma. GSK were fined, that magic number of, $3 billion, about 6 times the fine on Barclays. Was GSK's crime 6 times worse than Barclays? If so why haven't there been calls for judicial or parliamentary investigations into the behaviour of the UK's pharmaceutical industry? If Barclays' sin was equivalent to GSK's, why the small sanction?

Could it be that the government spending money on bio-tech research puts the industry under public scrutiny, this puts pressure on the regulator to ratchet up the sanctions. Bankers pour money into the coffers, rather than take money out, on condition that the government leaves the industry to its own, hidden, devices.

All these calls for a judicial enquiry into the behaviour of the UK banks are a bit lame, in my opinion. There has recently been an excellent judicial review of practices in financial services, Lord Penrose's Review of the collapse of Equitable Life. The Equitable was the world's oldest public (i.e. open to all) life insurers that collapsed around the time that LTCM collapsed, essentially the firm had been giving away long term swaptions (Guaranteed Annuity Rates), rather than providing them at a cost. The "hole" that the Equitable left was estimated at the time as about the same size as the LTCM hole (around $3 billion), though as the Equitable was a life company the current loss suffered by policy holders is in the region of £4 -£5 billion (note the change in currency). The government at the time asked the Scottish Judge, George Penrose, to conduct a review of the collapse in 2001 and he reported in 2004. Some quotes:

One of the regulators involved with Equitable referred to the boundary between prudential and conduct of business regulation as more an awkwardness than a lacuna. While that may be a fair comment on how the two branches were intended to operate, in practice the lack of co-ordination of prudential and conduct of business regulation in relation to the Society was unacceptable. (ch 20, 64)

Many readers of this report will be frustrated that it has not provided answers to two questions: who is at fault for the problems encountered by the Society, and who deserves redress as a consequence? It has been no part of this inquiry to attempt to answer either question. The first inevitably involves issues of the scope of duty and of breach of duty that I was not asked to consider and that I would have been unwilling to consider as part of an inquisitorial process. The current proceedings at the instance of the Society speak eloquently of the complexity of the questions that arise from allegations of breach of duty relating to a relatively short period compared to the period covered by the inquiry, and a selection of issues from the wider range that I have discussed. An open adversarial process such as would have been necessary to replicate the litigation process over the longer period and the wider range of issues would have been beyond contemplation. (ch 20, 77, my italics)

Almost 10 years on, it seems, not much has changed, apart from in 2010 the government agreed to compensate the policyholders for the lax regulation. A few weeks ago I received a cheque for £159, some 15 years after the firm collapsed.

It is interesting that in 1998, LTCM collapsing owing $3 billion spawns congressional hearings, books and TV programmes, by 2012 $3 billion is a corporate fine.

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About Me

I am a Lecturer in Financial Mathematics at Heriot-Watt University in Edinburgh. Heriot-Watt was the first UK university to offer degrees in Actuarial Science and Financial Mathematics and is a leading UK research centre in the fields.

Between 2006-2011 I was the UK Research Council's Academic Fellow in Financial Mathematics and was involved in informing policy makers of mathematical aspects of the Credit Crisis.